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The economy and markets
Key points to know
Recession? Probably, but not yet.
The global economic expansion is three years old — young compared to history, as the last three growth cycles lasted an average of nine years. But expansions don’t die of old age; they usually end due to an external shock, often from monetary policy. With that in mind, the odds of a global recession can’t be discounted, especially after many central banks have spent the past year resolutely raising rates to battle inflation. In the U.S., many leading indicators have softened (including the ISM manufacturing survey and lending activity), while the Treasury yield curve remains inverted. This points to the likelihood of a U.S. recession of limited magnitude and duration in the medium term. Outside the U.S., the eurozone economy has already contracted slightly for two consecutive quarters, and the U.K. is also flirting with negative growth. We don’t expect a long or severe global recession, but our base case calls for a mild one emerging in 2024.
Inflation and the labor market: all gain, no pain.
Heading into 2023, we believed further easing of inflation was in store, accompanied by weaker growth and higher unemployment. While inflation has indeed moderated so far this year, economies have not yet paid a substantive price in terms of labor market or broader economic pain. In fact, GDP growth accelerated in the U.S., Europe and China in the first quarter. Across developed market economies, unemployment remains broadly lower than it was pre-Covid (Figure 2). With housing inflation starting to roll over and oil prices down nearly 30% from a year ago, the ingredients for benign disinflation are coming together. That said, continued progress will be uneven, and we still expect U.S. core inflation to be near 4% at year end — double the Fed’s 2% target.
We expect a mild global recession to materialize in 2024.
Interest rate cuts aren’t coming soon.
With labor markets remaining resilient and inflation moderating, some investors are betting on rate cuts in the second half of the year. We think that projected time frame is too early. Policymakers are unlikely to flinch in their fight against inflation unless it returns to its target level or the employment situation begins to show more worrying signs of weakness. We don’t expect either of these to happen until the end of 2023 at the earliest. On the contrary, additional rate hikes are more likely than rate cuts this year if the economy continues to perform well and the eventual recession doesn’t arrive until sometime in 2024, per our current outlook.
Keep an eye on the tail risks.
Investors should stay mindful of various upside and downside risks that have the potential to complicate our base case for a mild recession. Among the downside risks: A deeper-than-anticipated downturn would probably cause central banks to start reversing their aggressive 2022 rate hikes. In addition, while the direct impact of recent banking stress appears to have been relatively modest (we estimate a -0.5% hit to 2024 U.S. GDP growth from tighter lending conditions), financial system uncertainty will persist, perhaps exerting a bigger drag. Such a result would favor more defensive portfolio positioning. On the upside, if stronger growth materializes, central banks may nudge interest rates higher from current levels. In this scenario, risk assets should perform well. Importantly, we wouldn’t expect cash to outperform in either scenario.
All market and economic data from Bloomberg, FactSet and Morningstar.
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A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not appropriate for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.
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